Europe's four big dilemmas

18 September 2011 Last updated at 18:08 GMT By Laurence Knight Business reporter, BBC News Decision time for the euro is fast approaching As Europe's leaders seemingly dance on the edge of disaster, what are the real problems facing the euro?

For many onlookers, the issues may seem complicated and interconnected.

But essentially they boil down to four big dilemmas.

And how these dilemmas are resolved will decide whether the eurozone stays together, or ultimately unravels.

What the market thinks of Greek government debt

Like the US and UK, Europe faces an enormous overhang of accumulated government and private-sector debt, much of which is now unrepayable.

So the question is, how much gets written off, and who picks up the tab?

For the eurozone as a whole, the debt problem is comparable with that of the US, and potentially manageable.

The problem is that some eurozone countries are much more heavily indebted than others.

Markets already assume that very soon Greece will have to write down its massive debt by at least half.

They also think the Portuguese, Irish, and even the Spanish and Italian governments, may eventually follow suit.

But when bad debts get written off, someone has to take a loss.

While some of those debts are held in the US, UK or elsewhere overseas, most of it is held by the European banks, and increasingly by the European Central Bank (ECB).

Germany may end up footing much of the bill

This is the primary reason for the recent loss of confidence in the European banking system.

But while Germany can afford to rescue its banks, as the Irish Republic has already demonstrated, other countries may not be able to rescue theirs.

So ultimately Germany and other less-indebted countries may have to bear much of the cost of rescuing the eurozone's banks as well as its weaker governments.

Like everywhere else, most European governments have seen their borrowing balloon during the recession and anaemic recovery.

At the same time, fears over southern European governments' ability to repay their debts mean their borrowing costs have also gone through the roof.

Under pressure from Germany and the ECB, all of these countries have been pushing through painful spending cuts and tax rises.

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Rate at which markets are willing to lend to governments for 10 years:

Germany: 1.92%France: 2.65%Spain: 5.25%Italy: 5.39%Ireland: 8.24%Portugal: 10.61%Greece: 19.12%

Source: Bloomberg. Data as of 16 September 2011

To set a good example, Germany has even donned the hairshirt itself, promising to eliminate its own modest deficit by 2013.

But here's the problem: Austerity is killing growth throughout Europe.

And with less profits to tax and more dole cheques to write, weak growth makes it even harder for governments to cut their borrowing and repay their debts.

In order to turn the slowing eurozone economy around, the ECB now looks set to slash interest rates from their current 1.5%.

The central bank may also buy up more Italian and Spanish debt, pumping cash into the financial system and easing the pressure on those countries to slash their borrowing.

But this move has been strongly opposed by German members of the ECB.

Another option to stimulate growth is for the few other countries that markets are still willing to lend to to borrow and spend more, offsetting spending cuts in southern Europe.

Yet for Germany, who can currently borrow at unprecedentedly cheap interest rates, borrowing is anathema.

Germany's view on the eurozone crisis is simple.

Southern European governments borrowed recklessly at the cheap interest rates available inside the euro.

Now they are being punished by markets, and must learn discipline.

Germany wants other governments to incorporate strict budget rules into their constitutions to stop such recklessness in future.

A 20% unemployment rate helped spark Egyptian-style mass protests in Spain

But rules, with penalties attached, may not be credible. Imposing a fine on an overindebted government is rather like kicking someone when they are down.

Indeed, just such a "stability pact" of budget rules, insisted on by Germany at the euro's creation, was quickly broken with impunity by Germany itself.

Moreover, the focus on discipline misses a bigger point.

While Germany's view may be apt for Greece - whose government cheated on its borrowing statistics to qualify for the euro in the first place - it is grossly unfair for Spain.

Before the financial crisis, Spain's government had lower debt levels than Germany's, and (unlike Germany) actually spent less than it earned in taxes.

But the country experienced a property bubble that then burst spectacularly, leaving its economy high and dry.

Wages, inflated during the good years, are now uncompetitive, and unemployment has shot up to 20%.

Detroit, in Michigan, has suffered an economic disaster, mitigated by US government money

Yet, inside the euro, Spain cannot devalue to regain a price advantage. Nor can it necessarily expect the ECB to cut interest rates or buy up its debts.

Being put a fiscal straitjacket as well just makes things worse.

Compare this with the US state of Michigan, where the collapse of the US car industry has spelled disaster.

Unlike in Europe, the US has a federal government that can tax other states in order to help out Michigan, by paying for unemployment benefits and rehabilitating the big car companies.

If the euro is to function in the future, economists warn, then a similar system of centralised fiscal transfers will be needed there too.

And in the current crisis, again it is Germany that would foot much of the bill.

On the face of it, the big political standoff in Europe is one of paymaster Germany versus bankrupt southern Europe.

For German voters, their country's post-War economic miracle was built on a hard currency, prudent finances, and strong exports.

It is hard for German voters to fathom that these very virtues are at the heart of the current crisis.

But Germany has everything to lose if it does not help the south out, and the eurozone unravels.

If the Greeks, Italians and others default on their debts, German and French lenders would be the biggest losers.

As Greece's economy shrinks and shrinks, its people cry out. But can German voters hear them?

If they also leave the euro, it would be a legal and financial disaster for all concerned.

Moreover, German export success for the past decade has been built on the weaker, more competitive exchange rate that came with sharing a currency with southern Europe.

Without the euro, safe haven Germany could expect its currency to shoot up, with devastating consequences for the country's export-driven industry.

Southern Europeans meanwhile would see their currencies plummet outside the euro, leading to rises in inflation and their cost of living as painful as the austerity they are protesting against.

Yet these stark realities are not widely appreciated in Germany or its neighbours.

Because the real problem is that there is nobody who can credibly speak for the common interest of Europe.

Since its inception in the 1950s, the European project has been run and controlled by a club of national governments.

The political process has been one of haggling behind closed doors, with issues presented to electorates as a matter of competing national interests.

But such haggling is dangerous in a financial crisis.

Jose Manuel Barroso: "The measures have taken too long and they have not been fully delivered"

Any solution must be agreed by 17 governments, and ratified by 17 parliaments, an impossibly slow process.

And the longer it takes, the more bitter the dispute risks becoming, and the greater the market's loss of confidence in the euro becomes, undermining Europe's fragile economy.

The European Commission president, Jose Manuel Barroso, has tried to speak for the common interest, pleading for the Commission to take the lead in solving Europe's problems.

But he is a political appointee, and as such, he is easily ignored by national leaders and scarcely noticed by the wider public.

Perhaps, if Mr Barroso were an elected leader, he could guide European public opinion towards a comprehensive solution to the crisis that balanced the interests of the different nations.

But as it is, the European public is very far from understanding the issues, or agreeing to the greater economic and political integration that may be needed to save the euro.

Sadly, this political dilemma is one that may not have a workable solution.

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Could Greece be Europe's Lehman?

14 September 2011 Last updated at 23:02 GMT By Laurence Knight Business reporter, BBC News Then and now: Washington thought pulling the plug on Lehman would send the right message; Brussels may face a similar decision over Greece Three years ago today, US Treasury Secretary Hank Paulson made a momentous decision - to let the investment bank Lehman Brothers fail.

The US government had helped to rescue a string of financial institutions, but markets kept pushing more to the wall.

Mr Paulson was running out of time and options. There was no political support in Washington to keep throwing money at the problem. Wall Street would just have to learn to bear the consequences of its own folly.

Today, many say that it was the wrong decision.

The resulting financial meltdown (the stock market plummeted 43%) forced the authorities to do exactly what they had been trying to avoid - commit trillions of dollars to rescue the financial system.

Plus ca change?

Now fast-forward to the present. The "troika" of lenders to Greece - the European Union, International Monetary Fund (IMF) and European Central Bank (ECB) - may soon face a similar moment of reckoning.

The government in Athens has consistently failed to cut its overspending as much as promised, and keeps coming back for more money.

The Greeks complain that spending cuts demanded by the troika are killing their economy, which in turn pushes their tax revenues down, stoking the need to borrow yet more.

But Germany and other lenders believe southern Europeans have lived beyond their means for years and must learn discipline.

Would they really pull the plug on Greece to make an example of it? Or, with daily protests on the streets of Athens, could Greece itself walk away from the table?

And if so, would it trigger another global meltdown?

Myopic politics

"In both cases, the authorities that could step in to rescue... don't want to commit," says former Bank of England economist Sir John Gieve.

Southern Europe and Germany are playing a game of brinkmanship over bailouts and austerity

Partly this is due to "moral hazard", he says, where rescuing a miscreant bank or government would just encourage more recklessness. Germany has one eye on Italy's half-hearted austerity attempts.

That creates a game of brinkmanship, with each side using the threat of catastrophe to win concessions - austerity versus bailouts.

"It's rational for everyone to take measures to prop the system up," says Sir John. "But because you're doing it on the brink of disaster, there is a risk you don't get your ducks in a row."

The bigger problem is political. The German government recently suffered a huge defeat in regional elections. Greek bailouts are not popular with German voters.

"Politics is not a rational process. Crisis creates myopia," says Jerome Booth, head of research at asset manager Ashmore. He thinks the bigger risk is of Greece pulling out: "All you need is for some politician to stand up and say 'vote for me and you don't have to pay your debts any more'."

Default and devalue

Certainly it would be irrational for Greece to stop playing ball. Cut off from the troika's bailouts, the country cannot borrow.

But even if it stopped paying its debts, Greece would still face enormous pain.

Last year the government borrowed the equivalent of 10.5% of annual economic output, just to fund general government spending.

Would cutting off emergency loans to Greece make a return to the drachma inevitable?

That overspend would have to stop immediately - far worse austerity than the troika demands. The Greek banks would also collapse, bereft of outside support.

Having crossed the Rubicon of unilateral default, many economists believe the Greeks would leave the euro altogether.

One reason is the need to devalue its currency to restore competitiveness. "Greece needs to move its exchange rate by at least 30% to have any chance of getting jobs back," says Mr Booth.

Another is that the Greek central bank could then fund the government's continued borrowing with freshly-printed drachmas. But inflation would soar, and imports especially would become very expensive.

Chain reaction

What would this mean for the rest of the world?

In 2008, banks worldwide had borrowed up to the hilt, and were unable to absorb the losses spreading from the US housing market.

That threatened a chain reaction of bankruptcies, which in turn caused a collapse of confidence throughout the financial system.

The resulting electronic bank run was the immediate cause of the meltdown. Banks, brokerages, insurance funds and speculators had relied on a steady supply of cheap, short-term funding, which suddenly vanished.

Banks have spent the past three years slimming down. They also rebuilt their capital, that is, their ability to absorb losses.

Continue reading the main story Reliance on short-term borrowing has also reduced, and central banks stand ready to provide the emergency loans that rescued the system last time round.

Moreover, this time the surprise factor may be missing.

"[Unlike Greece] Lehman's death throes didn't last two years," points out Sir John Gieve. "Banks have already written down [Greek] debts substantially."

Legal mess

Even so, Europe's banks are still widely seen as the continent's Achilles' heel, with their share prices down 50-70% over the past six months.

European regulators conspicuously side-stepped the possibility of a government debt default when carrying out "stress tests" to check the resilience of banks.

But this has just increased uncertainty about who would suffer most after a default, undermining confidence in all banks.

There is evidence suggesting the European banks themselves have already been quietly shifting their cash out of Europe over the summer, while one French bank is now reportedly finding it impossible to borrow in dollars.

Mr Booth thinks some banks may not withstand deep losses on Greek government debt, say up to 75% of their original value, and a simultaneous collapse of Greek banks.

And a Greek euro exit would create a huge legal mess: does Greece have the right to leave the euro? Can companies convert contracts in euro into devalued drachmas? How would personal savings and borrowings be converted?

Financial drip

Economists say the greatest damage from a Greek default or euro exit could be from the example it sets. Unlike 2008, there is now a second and more worrying channel for financial contagion: government debt.

During the latest jitters, markets have been differentiating more sharply than ever between safe Germany and risky southerners. Why lend to a country that could follow Greece's lead and default, or convert your euro cash into e.g. devalued lira?

The concern at the front of every European leader's mind is that investors may stop lending to Spain and Italy - economies that together are more than ten times the size of Greece.

Continue reading the main story

Rate at which markets are willing to lend to governments for 10 years:

Germany: 1.74%France: 2.55%Spain: 5.36%Italy: 5.69%Ireland: 8.45%Portugal: 10.76%Greece: 21.25%

Source: Bloomberg. Data as of 13 September

Already the two have been put on an ECB financial drip.

"There needs to be a clear perception that other countries do not have the same problem [as Greece]," says Mr Booth.

He thinks austerity programmes are going a long way to achieving this distinction.

Growing pains

But other economists warn that austerity worsens a different problem that many southern Europeans share with Greece.

Thanks to rising wages during the boom years, they all have seen their competitiveness versus Germany steadily eroded, but as they are in the eurozone, they cannot restore it by devaluation.

And with Germany insisting that all governments - including itself - slash spending, economic growth is under threat. That in turn makes their debts even harder to repay.

The problem is compounded by the ebbing away of confidence in their banks, making it harder for them to borrow the money needed to support the economy.

Indeed, without German financial support, it may be beyond the means of Italy and Spain, and even France, to rescue their banks while remaining in the euro, undermining confidence further.

Yet the failure of a major European bank would be as unmanageable now as in 2008, and liable to spread the financial crisis across the globe.

Economists say the solutions to the crisis are within Europe's means. The problem is the unwillingness of politicians to take the necessary steps because they rankle and lose votes.

So, just as with Lehman Brothers, the big question for markets now is: how big does the financial crisis need to get to create political resolve?

Or will the politicians run out of time first?

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